December 1, 2014

The Case for a Carbon Tax is Much Weaker Than You Think

December 1, 2014

The “carbon fee”—not a tax mind you—legislation introduced by Senators Whitehouse and Schatz epitomizes the dual reality in the debates over climate change policy. The commentary on the bill would lead the innocent reader to believe that this is textbook economics in response to a “market failure.” In reality, using the very same textbook economics and taking all of the Obama Administration computer models at face value, I will show that the proposed carbon tax is not at all suitable to the alleged problem. To repeat, the proposed U.S. carbon tax is unjustified on its own terms; one doesn’t have to be a “denier” and question the underlying assumptions about physical climate change.

Whitehouse’s American Opportunity Carbon Fee Act, which is cosponsored by Senator Brian Schatz (D-HI), would correct a market failure that currently allows polluters to push the costs of their pollution onto everyone else.

…

The American Opportunity Carbon Fee Act would require polluters to pay a fee for every ton of carbon pollution they emit. The fee would start at $42 per ton in 2015 and increase annually by an inflation-adjusted 2 percent. The price of the fee follows the Obama Administration’s central estimate of the “social cost of carbon,” the value of the harms caused by carbon pollution including falling agricultural productivity, human health hazards, and property damages from flooding. [Bold added.]

The above description makes the proposed carbon tax sound oh-so-scientific and calibrated; one gets the idea of people in white lab coats finely turning a dial. But even on its own terms, if the U.S. government enacts a carbon tax equal to the “social cost of carbon” estimate, that is far too high and causes an inefficient amount of economic damage. To repeat, the points I am going to make in this post are taking the standard textbook case at face value; I am showing that these results are being misapplied in the political arena.

The truly interested reader can read through my commentary (Part I and Part II) on IER’s formal Comment on the Social Cost of Carbon submitted to the Office of Management and Budget. But for our purposes here, let me summarize some of the essential points, to show why the proposed carbon tax—or excuse me, “fee”—is far too high.

In theory, the social cost of carbon (SCC) is the present value summing up all of the future net climate change damage that an additional ton of carbon dioxide emissions will yield, centuries into the future. There are various computer models that the Obama Administration selected to estimate this value, and (with various parameter choices) the number they’ve settled on is $42/ton for 2015. Let’s stipulate that that is a reasonable estimate.

Going From “Social Cost of Carbon” to Government Policy

Now, if we want to use textbook economics and have the government set a tax equal to the SCC, this really only makes sense if we are imagining: (1) a worldwide government setting a uniform carbon tax of $42 on all emitters of CO2; (2) that this worldwide government initially had no other taxes or penalties on emissions, or subsidies/mandates for non-carbon-intensive fuels; (3) this worldwide government initially had no other distortionary taxes on labor or capital; and (4) the revenue from the new carbon tax were returned as cash payments to citizens for them to spend as they pleased. Under these further assumptions, then the standard economics textbook treatment of “negative externalities” like pollution would imply that this worldwide government should enact a new carbon tax equal to the SCC, or $42/ton in this case.

Yet notice that in the real world, not a single one of these assumptions applies. First of all, the U.S. government does not have the power to compel other governments around the world to join in the carbon tax scheme. Climate scientist Chip Knappenberger recently estimated that the IPCC’s own models and parameter choices indicate that if the United States suddenly ceased all carbon dioxide emissions, while other countries continued on their baseline emission paths, then in the year 2100 the global temperature would be a whopping 0.2 degrees Celsius cooler than otherwise. Thus, even a draconian carbon tax imposed unilaterally by the U.S. government would be virtually insignificant if it merely displaced emissions into other jurisdictions.

Furthermore, even if we set aside the problem of “leakage,” there is still the matter that the U.S. and state governments already impose significant penalties on CO2 emissions, and give subsidies and mandates encouraging “alternative” technology and fuels. For example, federal and state gasoline taxes were not set up as carbon taxes, but to the gasoline consumer they have a similar effect. Currently, federal and state gas taxes average about 42 cents per gallon, which is higher than what the “optimal” tax on a gallon of gas (about 37 cents) would be, if the social cost of carbon were indeed $42/ton.

To carry this point further, Sens. Whitehouse and Schatz should also put in their bill the elimination of the ethanol mandate, the EPA’s power plant regulations, all CAFE standards on fuel economy, all energy efficiency mandates, and they should remove all regulatory hurdles for the Keystone Pipeline—after all, once their proposed carbon tax has cured the “market failure,” we should let individual businesses and households choose their optimal behavior guided by the market. That’s what the textbook analysis says, upon which they rest their legislation. Are they willing to do all of that, or do they not actually believe in the textbook treatment of negative externalities after all? These considerations show that the Whitehouse and Schatz plan isn’t really about adjusting the “costs of pollution” but instead is about giving the federal government more control over the economy, and energy sector in particular.

The Crucial “Tax Interaction Effect”

Returning to our list of assumptions, the third element was that a worldwide carbon tax of $42/ton only made sense if we started out with a blank slate. But if instead there are already distortionary taxes on labor and capital, then in general we would expect the new carbon tax to hurt the economy even more. In this post I walk through the logic of this “tax interaction effect” more carefully, but suffice it to say that the peer-reviewed literature says that correcting for this real-world complication most likely will significantly lower the “optimal” carbon tax; it won’t be the $42/ton that the computers spit out for the “social cost of carbon.”

Will All Revenue Be “Returned to the Citizens”?

The last piece in the standard textbook case is that the government should take all of the revenue raised from a tax on a negative externality and return it to the public in a way that doesn’t itself invite inefficient behavior. For example, it would obviously screw things up if the government handed out carbon tax revenue according to how much money a firm had lost in the previous quarter; this policy would subsidize unprofitable companies.

Now let’s go back to the press release and see how Sens. Whitehouse and Schatz plan on meeting this requirement so that the professional economists can give their legislation a blessing:

All revenue generated by the carbon pollution fee – which could exceed $2 trillion over ten years – would be credited to an American Opportunity Fund to be returned to the American people. Possible uses include:

Economic assistance to low-income families and those residing in areas with high energy costs

Tax cuts

Social security benefit increases

Tuition assistance and student debt relief

Infrastructure investments

Dividends to individuals and families

Transition assistance to workers and businesses in energy-intensive and fossil-fuel industries

Climate mitigation or adaptation

Reducing the national debt

Whoa whoa whoa, hold on a second. There are several items on the above list—including “infrastructure investments” and “climate mitigation or adaptation”—that are clearly examples of more government spending. If the carbon tax money spent on building a new road or bridge is considered “returned to the American people,” then nothing the federal government does could possibly violate that promise.

Conclusion

The proponents of an aggressive U.S. government carbon tax have tried to paint the matter as “settled science” and have castigated any critics as ignorant or dishonest boors. Yet even if we take the standard economic case for taxing “negative externalities” at face value, and even if we agreed for the sake of argument with the computer models’ estimates of the “social cost of carbon,” it would not follow that the U.S. government should impose a carbon tax. Once you correct for the various complications I’ve described previously, a quite reasonable guess for the “optimal carbon tax” is $0 per ton.